The S&P 500 Temperature can be measured by comparing the actual current level of the S&P index to the level at which certain expiring $SPY options (Covered Calls opened at-the-money 4-months ago) would break even when they expire this week.

When the Temperature is high, it signifies that the stock market is hot; and folks are in the mood to buy. A low temperature indicates that the mood for buying has cooled off and traders are more likely to want to sell on a rally so they can get out of their positions on a high note. Any Temperature above 200 is not just hot, but scorching hot.

The Temperature is not only affected by changes in the S&P 500 index itself, but also by changes that happened months ago. If, for example, the S&P was rising quickly 4-months ago, then the level required for break-even on expiring Covered Calls will be rising today. Thus, the S&P would need to rise just to keep pace with the rise in the Covered Call break-even point in order to keep the Temperature constant.

Without a rise in the S&P index, the Temperature can actually fall; and in some cases that’s true even if the S&P remains flat; and in extreme cases the Temperature can fall even as the S&P is rising.

Just last week the Temperature was 385, yet this week it is only 272. The change did not come from a drop in the S&P but from an increase in the level that would be required for this week’s expiring Covered Call options to break even.

The Temperature is determined by measuring the distance of the current S&P level from the red line – the level at which those expiring Covered Calls would break even, and the level that tends to divide bullish sentiment from a bearish one. The following chart illustrates the reason the Temperature has dropped so precipitously this week without a corresponding fall in stock prices in the S&P index.

Since the Temperature tends to correlate with sentiment, bullish sentiment can actually decline as the S&P rises. It is an uncommon event; but it is happening currently. The break-even level for expiring at-the-money Covered Calls that were opened 4-months ago is rising quickly. Therefore, if the S&P doesn’t rise quickly now, the Temperature will fall, and bullish sentiment will likely decline with the Temperature decline.

The choice of using 4-month options to measure the Temperature is somewhat arbitrary. One could use 1-month, 3-month or 6-month-out options and get similar results, and each would have different effects when calculating the daily Temperature. But, using the criteria in the chart above, the S&P tends to end up in the same zone regardless of the choice of option expiration date. Therefore, daily fluctuations in the Temperature are not as important as the zone the S&P ends up in.

Lottery Fever is Lottery Fever regardless of whether one chooses to use a 1-month option or a 6-month option as a baseline indicator; and Lottery Fever does indeed have an upper limit.

It’s not an exact science, but Temperature definitely has a correlation to sentiment among traders. If the recent intense, even record-setting heat diminishes, it will likely correlate with a diminishing in trader’s willingness to purchase stocks. Since many stocks in the S&P are near all-time highs, a diminishing in demand for buying has the potential to set off a pullback. It won’t necessarily result in a pullback though, because if the S&P continues to rise at its recent pace, the Temperature could stay as hot as it is right now. But, if the S&P starts to consolidate sideways or pull back a bit, the Temperature will fall, and the decrease in bullish sentiment that generally accompanies falling Temperatures could lead to some impressive sell-offs in stocks.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca